The decline of inflation and the bull market of 1982-1999

If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market starting in 1982 was partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer from inflation illusion, resulting in the undervaluation of equities in the presence of inflation, with levered firms being undervalued the most. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices. Our misvaluation measure can be used with expected inflation to make statistically reliable predictions for real returns on the Dow during the subsequent year. Our model suggests that stocks were overvalued at the end of the 1990s.